“The Berlin Stock Exchange in Imperial Germany”

Frankly, I was surprised to see this new paper (ungated working paper version) by Sibylle Lehmann-Hasemeyer from Hohenheim and JochenStreb from Mannheim being published in the American Economic Review. The context seems to be quite specifically focussed on Germany with no immediate policy lessons for the US. And innovation is usually not the most prominent topic in the AER either. But all the better!

It’s a very interesting read (and not too technical). The main message is this: Germany appears to be the prototype of a bank-based financial system throughout history. Compared to a market-based system—as for example in the US, where many more firms rely on issuing stocks and bonds to finance their business—this is perceived to have disadvantages when it comes to R&D investments. Banks might be too risk-averse to finance innovation at an optimal scale or might want to shield their incumbent customers from new competition. And the entire venture capital industry relies on succesful firms going public as an exit strategy. This paper now presents convincing evidence that although Imperial Germany during 1892 and 1913 was strongly dominated by large banks (Deutsche Bank, Dresdner Bank, etc) the Berlin stock market was nevertheless quite effective in providing fresh capital to startups in the high-tech industries of the time.

I will quote their conclusion here but urge you to read the whole paper:

In the decades before the First World War, Germany changed from a comparatively backward country to a global industrial leader, especially excelling in new and innovative industries such as chemicals, electrical engineering, or machine building. Until now, however, the question of how German firms were able to finance their very risky innovation activities has remained widely unanswered. This paper shows that many innovative companies used the Berlin stock exchange as a source of financing. Even more surprising is the fact that innovators were not penalized by relatively high initial returns or low first trading prices. On the contrary, innovative startups that needed equity capital to run their risky R&D projects realized comparatively high offering prices and, in the longer run, they performed no worse than more seasoned corporations. Our findings suggest that, in the decades before the First World War, the Berlin stock exchange worked as an efficient market for new technology that channeled equity funds from non-innovative firms to innovative ones.

It might therefore be misleading to interpret nineteenth-century Germany’s financial sector as the textbook example of a bank-based financial system. It is true that Germany had a well-developed banking sector with large universal banks, many small savings banks, and credit cooperatives. But the German economy could also rely on the large and efficient Berlin stock market with a market capitalization above the world average (Rajan and Zingales 2003) and, in terms of efficiency, on a par with London (Gelman and Burhop 2008; Burhop, Chambers, and Cheffins 2011). To conclude, Germany’s industrialization and innovation depended much more than previously assumed on the provision of equity capital.